Puerto Rico bonds have become the latest toxic investment sold to unsuspecting investors by mutual fund managers including big-name portfolio managers like OppenheimerFunds. Puerto Rico has unloaded more than $70 billion in outstanding debt onto investors in major mutual funds. These bonds have lost significant value during the past year and there are ongoing concerns about default. As a result, Puerto Rican bonds have been downgraded to near-junk status.

In light of the crisis, which is largely affecting investors who had no idea of the risk they were taking, the top securities regulator in Massachusetts has indicated that he may ask the U.S. Securities and Exchange Commission to change a rule allowing money managers to move high concentrations of troubled Puerto Rico bonds into state-specific municipal bond funds.

Puerto Rico Bond Funds in Serious Trouble

In light of the concerns about Puerto Rico’s ability to pay its debt, the S&P Municipal Bond Puerto Rico index is down 21 percent in 2013. This is a major decline for investors who typically choose municipal bond funds because these funds generally offer a safe and low-risk investment.

Puerto Rican debt makes up a huge portion of the $3.7 trillion U.S. municipal bond market, with around 180 funds having weightings of five percent or greater in Puerto Rico bonds. The 180 funds that are heavily exposed to Puerto Rico bonds have more than $100 billion in net assets. These funds, however, may not even be the ones at the greatest risk.

State-specific municipal bond funds, such as the John Hancock Massachusetts Tax-Free Income Fund, may have even greater exposure to toxic Puerto Rican debt. The Massachusetts fund and many other state-named funds have more than 10 percent of assets in Puerto Rican debt. These state-specific funds have high exposure to Puerto Rico debt because the Securities and Exchange Commission currently allows single-state municipal bond funds to invest not just in debt issued by their own state, but also in any tax-exempt bonds. Puerto Rico bonds are tax-exempt in every state, and fund managers who want to generate higher yields than the state funds provide have increasingly been buying up Puerto Rican debt.

The Massachusetts’ securities regulator is concerned about the potential risk exposure and about the fact that mutual fund managers can take advantage of legal loopholes under the SEC’s current regulations by buying riskier funds, such as Puerto Rico. Like with most mutual funds that have invested heavily in Puerto Rico bonds, it is possible that fund managers have not made an effort to explain to those depending upon the funds that the Puerto Rican debt is a risky investment.

While the investigation into the fund investments in Massachusetts is still in its early stages, the top securities regulator’s indication that he may ask the SEC to change its regulation could have significant ramifications for the bond market. Of course, a change in regulation will come too late to avoid the significant losses that have already occurred because of heavy investing in risky Puerto Rico bonds.

Investors who face losses and who were unaware of the risks their fund managers were taking may be able to make a legal claim to recover their money. An attorney should be consulted by those who suffered losses.